Wednesday December 19, 2018

Article of the Month

IRS Tax Treatment of Cryptocurrency

Introduction

Cryptocurrency is an encrypted form of digital virtual currency which has grown in prominence, as its most popular variant, Bitcoin, has exploded in value
in recent years. With increased popularity comes increased curiosity as to the tax treatment of cryptocurrency. Many cryptocurrency owners have held onto
this unique asset for a number of years, amassing enormous growth. Programming changes have left many cryptocurrency owners holding several forms of digital
assets. These owners now wonder how their digital currency will be taxed if they transfer it and whether charitable solutions exist similar to those for
gifts of cash or appreciated property.

The IRS addressed several questions related to the taxability of virtual currency when it issued Notice 2014-21. However, certain questions remain
unaddressed by the Service. This article will explore the basic function of cryptocurrency and the tax treatment surrounding transfers of cryptocurrency.

What is Cryptocurrency?

While Bitcoin may, at times, seem to be virtually synonymous with "cryptocurrency," it is merely the most prominent member of its class. Other
cryptocurrencies, such as Litecoin, Ethereum and Ripple have become major players in the world of virtual currency. The rise in popularity of cryptocurrency
has led to questions about what it is and how (or even whether) it is taxed.

In 2014, the IRS took a first step toward addressing the taxation issues surrounding virtual currencies. In Notice 2014-21, the IRS defines virtual currency
as "a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value." Virtual currency has been touted
in recent years as a potential replacement for standard currency. Whereas standard currency is issued and regulated by a governmental entity, virtual
currency is usually decentralized and is not issued by any government.

Cryptocurrency is a subset of virtual currency. It is distinguished by its use of cryptography for security. Cryptocurrency transactions are recorded on a
digital ledger known as a blockchain. As its name suggests, each transaction for the cryptocurrency creates a new block in a chain of transactions. The
ledger is stored in various places and contains cryptographic identifiers, known as hashes. Each block in the chain contains its own hash and that of the
previous block. The presence of these identifiers and the wide distribution of the ledger greatly reduce the blockchain's susceptibility to tampering.

How is Cryptocurrency Treated by the IRS?

According to Notice 2014-21, cryptocurrency is treated as property. A taxpayer who acquires virtual currency as a payment for goods or services has a cost
basis equal to the fair market value of that virtual currency on the date of transfer. Any gain or loss related to the sale of cryptocurrency is treated the
same as a sale of other appreciated or depreciated property.

The type of gain or loss the taxpayer must recognize upon disposition of virtual currency "depends on whether the virtual currency is a capital asset in the
hands of the taxpayer." Notice 2014-21 notes the difference in the tax treatment of capital assets, such as stocks and bonds, from non-capital assets, such
as inventory. Therefore, if the taxpayer holds the virtual currency in a manner consistent with the capital asset rules, it will be taxed in the same manner
as a capital asset upon disposition.

Bitcoin, for example, was created in 2009 using an algorithm that limits the total number of possible Bitcoins in existence to 21 million. New Bitcoins are
discovered through a process called mining. The mining process involves the use of particular software to solve a complex equation. As more Bitcoins are
discovered, the difficulty of the equations increases. In Notice 2014-21, the IRS explained that a taxpayer who has mined Bitcoins or other virtual currency
has generated ordinary income through the mining activity.

If an individual holds Bitcoins or other virtual currency as a dealer-one who holds it as inventory-any increase in the value of the virtual currency will
be treated as ordinary income. In contrast, a non-dealer individual investor will hold the virtual currency as a capital asset. The taxpayer will realize
capital gains upon sale of the property.

Example 1

Amy operated a successful Manhattan restaurant. One day, in the summer of 2010, she received an odd request from a potential customer. He called in a
takeout order and was interested in paying with Bitcoin. Having heard of Bitcoin, and willing to take a risk on a small order, Amy accepted the order and
received payment of 5,000 Bitcoins in exchange for the entrée. On the date the purchase was made, the fair market value of 5,000 Bitcoins was $20.

Although amused by the transaction, Amy filed away her receipt and forgot about her modest Bitcoin holding until a news article discussing the rising value
of cryptocurrencies caught her eye three years later. After digging up her information, Amy was elated to find that her 5,000 Bitcoins were now worth
$3,000,000. Amy decided that she did not want to risk a tremendous loss in value by holding onto the Bitcoins for any longer. She quickly decided to sell
the Bitcoins, putting some of the cash toward paying off loans and using the rest to expand and improve her restaurant.

Having sold the Bitcoins for $3,000,000, with a cost basis of $20, Amy incurred a capital gain of $2,999,980. At the top capital gains rate of 23.8%, Amy
had a tax bill of $713,995 from the sale. She therefore received $2,286,005 from the sale of her once $20 asset.

Using Cryptocurrency to Fund a Charitable Gift

Because holders of virtual currency face the same capital gains tax ramifications as owners of other appreciated assets, many will find similar charitable
solutions to be attractive. Outright gifts, charitable gift annuities and charitable remainder trusts are all potential solutions to the capital gains tax
problem. As with other gifts of appreciated property, it is important to keep in mind that the donor will need a qualified appraisal in order to
substantiate the value of a donation of virtual currency in excess of $5,000 in value.

Advisors and donors should be mindful that the relative novelty of cryptocurrency could be an obstacle in circumstances where owners wish to transfer
ownership of these digital assets to charitable organizations. While there are many organizations that have begun accepting cryptocurrency donations, there
are many others that have not yet tested the waters. For these organizations, charitable gifts that require a transfer of legal ownership directly to the
charity may not be an option.

One alternative solution is for the owner to establish a charitable remainder trust, naming the charity as the beneficiary of the trust. The owner then
transfers units of cryptocurrency to the trust, which may then sell the cryptocurrency and reinvest. This generates both a payout stream and a charitable
deduction for the donor and a residual benefit for the charity, without the charity having to take ownership and possession of the cryptocurrency.

Example 2

Instead of selling her 5,000 Bitcoin, Amy's tax advisor recommends that she consider creating a charitable remainder unitrust with a portion of her
cryptocurrency and sell a portion. This strategy will allow her to offset a portion of her capital gains tax from the sale of her Bitcoin holding with a
charitable deduction. She would receive an immediate lump sum of cash from the sale and lifetime payouts from the unitrust. Working with her advisor, Amy
determines that she can zero out the taxation on the sale of $1,120,500 worth of Bitcoin if she uses $1,879,500 to fund a one-life charitable remainder
unitrust. She will bypass a portion of her capital gains by funding the unitrust and will receive an initial annual payout of $93,975, which could increase
over time, depending on the performance of the trust's investments. Given her age at the time the trust is created, she may have 30 years of payouts,
potentially totaling $3,263,000.

Determining the capital gains allocated to a cryptocurrency can be relatively straightforward. For cryptocurrency acquired by purchase, the owner's cost
basis is equal to the amount paid for the property. The cost basis of a cryptocurrency received as a payment for goods and services is the fair market value
of the cryptocurrency on the date of receipt. However, there are other ways a taxpayer may acquire cryptocurrency, which can make the valuation process more
difficult.

Cryptocurrency Forks

When a software coding change is proposed to a cryptocurrency, the change will bring about what is called a fork. The fork creates an alternate path in the
blockchain. A fork may either be a soft fork or a hard fork. A soft fork will result in a change to the makeup of all future blocks in the blockchain. This
might occur if there is agreement as to how the blockchain should be modified. While there is a change to all future blocks in the chain, no new asset is
created in the hands of the owner of the virtual currency.

A hard fork, on the other hand, creates two divergent paths for the blockchain, resulting in completely separate cryptocurrencies. Anyone who owns units of
a particular cryptocurrency prior to a hard fork will continue to own the same number of units of that cryptocurrency, along with an identical number of
units of the new cryptocurrency.

Bitcoin, for example, has experienced multiple hard forks. On August 1, 2017, Bitcoin owners received the newly created Bitcoin Cash in an amount equal to
the number of Bitcoins that the owner originally held. Similar hard forks occurred on October 24, 2017 and February 28, 2018, creating Bitcoin Gold and
Bitcoin Private. Anyone who held units of Bitcoin prior to August 1, 2017 and did not dispose of them prior to March of 2018, subsequently held an equal
number of units of Bitcoin, Bitcoin Cash, Bitcoin Gold and Bitcoin Private. Hard forks have the potential to generate extra value for the owner of
cryptocurrency, since the holder of one unit of a particular cryptocurrency can eventually become the holder of units of multiple distinct and separate
cryptocurrencies following a series of hard forks. However, this increase in value to the owner depends on the ability of the new cryptocurrency to gain
traction in the market. If the new cryptocurrency is not well-received, the owner may end up with little or no increased value.

The pressing question for the owner of cryptocurrency acquired through a hard fork is whether the new property is treated as taxable income. Under IRC Sec.
61, gross income is defined as "all income from whatever source derived." Absent specific guidance from the IRS to the contrary, the most conservative
approach is to treat the new cryptocurrency as ordinary income on the date it is created. Under this theory, the cryptocurrency owner will realize ordinary
income for the year in which the hard fork occurred, equal to the new cryptocurrency's fair market value on the date of the fork.

Example 3

Tim purchased three units of the latest and greatest cryptocurrency, OldCoin, a few years back for a total of $300 as a long-term investment. The value of
Tim's three units of OldCoin has reached $8,200. Tim is aware that OldCoin experienced a hard fork on the first day of December and decided to meet with his
advisor to determine the effect of the hard fork on his small cryptocurrency investment. Tim's advisor explains that, due to the hard fork, Tim now owns
three units of OldCoin and three units of NewCoin. The advisor then tells Tim that he may need to report the value of the new cryptocurrency as ordinary
income on his tax return. Tim and his advisor determine that each unit has a fair market value of $250 on the date of the hard fork. Because Tim holds three
units of an entirely new asset at $250 per unit, he will recognize an additional $750 in income for the year. Tim accordingly reports the small bump in
income for his 2017 taxes.

Tim decides to hold onto the three OldCoins and three NewCoins for five years, at which point his original three units have appreciated to a total value of
$20,000. His newer cryptocurrency has reached a fair market value of $10,000. Eager to cash in on his modest $300 investment, Tim decides to sell all six of
his cryptocurrency units for a total of $30,000. He returns to his advisor and asks what the tax consequences of the sale will be. Because Tim has held the
cryptocurrency for more than one year, his advisor explains that Tim will be taxed at long-term capital gains rates for the sale. Tim's basis in his OldCoin
units will be the $300 that he originally invested. Therefore, he will have $19,700 in taxable capital gains upon the sale. His NewCoin units have a cost
basis of $750, with capital gains of $9,250.

In a letter dated March 19, 2018, the American Bar Association (ABA) Section of Taxation submitted comments to IRS Acting Commissioner David Kautter,
seeking updated IRS guidance on cryptocurrencies and offering recommendations, specifically related to the tax treatment of cryptocurrency hard forks. Among
its suggestions, the ABA recommended that the IRS create a temporary safe harbor for cryptocurrency holders who experienced a hard fork in 2017. The ABA
Section of Taxation cited "difficult timing and valuation issues" as the impetus for the suggested safe harbor rule. The date on which an owner takes
possession of a unit of cryptocurrency has been the subject of debate and may depend on whether the owner holds the unit directly or through an
intermediary. A similar difficulty arises as to the valuation of the new cryptocurrency, as there are various online exchanges, each of which may provide a
different estimated value on the starting date.

The ABA's proposed temporary rule would treat a hard fork as a taxable event whereby the owner of the original unit of cryptocurrency would realize taxable
income with a zero basis in the newly created unit of cryptocurrency. The taxpayer would then have a capital asset that will have capital gain treatment
after the owner has held it for more than one year.

Example 4

Instead of treating the NewCoin as an accession to an additional $750 of wealth in the tax year, Tim and his advisor decide to take a more aggressive
approach and claim that Tim's three units of NewCoin had a zero basis on the date of the hard fork. Therefore, his adjusted gross income for the year is not
affected by the hard fork. When Tim sells his NewCoin holdings five years later for $10,000, however, he will recognize $10,000 in capital gains.

The ABA's request for updated IRS guidance is just one of many attempts to clarify the tax treatment of cryptocurrency. The IRS has not responded to the
ABA's request, or other similar requests for guidance, choosing instead to remain silent in the years following the release of Notice 2014-21. Professional
advisors, therefore, are left to determine the proper treatment of their clients' cryptocurrencies by applying general principles of law, despite the fact
that those general principles may not be directly on point for this relatively new type of asset.

Conclusion

Cryptocurrency is a new and constantly developing facet of the 21 st century economy. While the IRS has provided certain guidelines as to its tax
treatment, and general principles of law can be used to fill in certain gaps, the ever-evolving nature of this new type of property means that additional
guidance will be required in the years to come. Nevertheless, appreciated cryptocurrency may be a good asset to use to fund a charitable gift, as the owner
may receive a tax deduction and be able to bypass capital gains on the cryptocurrency.

The current limited nature of the IRS's guidance regarding the tax treatment of cryptocurrencies affects owners, tax professionals and charitable gift
planners, causing uncertainty over the value of potential donors' cost basis and capital gains in their cryptocurrency holdings. Cryptocurrency owners
should seek guidance from their professional advisors prior to acquiring, selling or donating units of cryptocurrency. Owners should also beware that they
may be deemed to have acquired new cryptocurrency during a given year, thus increasing their adjusted gross incomes, due to a hard fork.

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